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Unfreezing Credit

CHICAGO – Little political enthusiasm exists for further support to the banking sector. One reason is that banks that received money in the initial rescues do not seem to have increased their lending, without which monetary and fiscal stimulus are unlikely to be effective. For banks to start lending again, even more intervention may be needed.

To see why, we need to understand why banks are still so reluctant. One possibility is that they worry about borrowers’ credit risk, though this would have to be extremely high to justify the complete cessation of long-term lending. A second possibility is that banks worry about having enough resources to meet their own creditors’ demands if they lock up funds in long-term loans. But the many central bank lending facilities that have been opened around the world should assuage these concerns, especially for large and well-capitalized banks.

On the other hand, perhaps banks’ reluctance to lend reflects a fear of being short of funds if investment opportunities get even better. Citicorp CEO Vikram Pandit said as much when he indicated that it was cheaper to buy loans on the market than to make them. And buying may get cheaper still!

Consider, for example, the real possibility that a large indebted financial institution faces a run on its deposits, as Lehman did, and starts dumping loans onto the market. Not only will those loans’ price fall if only a few entities have the spare funds to buy them, but other distressed entities’ scramble to borrow also will make it hard for any institution without funds to obtain them. Anticipating the prospect of such future fire sales (of loans, financial assets, or institutions), it is understandable that even strong banks will restrict their lending to very short maturities, and their investments to extremely liquid securities.